Dual Range Accruals: Rate-Spread Risk and Investor Economics

# Rationale for the CMS Spread and CMS Rate as being underlying for Dual Range Accrual?


# Rationale for the CMS Spread and CMS Rate as being underlying for Dual Range Accrual?












I was searching on the products issued by the banks to retail investors, and saw some of the Dual Range Accruals having underlying as USD CMS 30Y - 2Y, and USD CMS 10Y, each having low barrier and high barrier respectively.

I understand it is quite obvious that we could think about the correlation and volatility since these two are the two most intuitive things that comes to mind when we think about the payoff condition of the Dual RA.

However it came to my mind that forward rates of USD CMS should also be the one that plays a significant factor. The spot rates of USD CMS 30y & 2y makes it feasible and reasonable for that spread to be an underlying having a lower barrier. However, when we think of the forward rate, it seems it has a very high possibility of reversal, which would be affected by the macro factors especially inflation rate and interest rate.

Is it just a simple rationale( for example, that's why long tenor would have higher coupon since it is exposed to more risk)? Or is there some other logics, especially in perspective of the traders, that would make these underlying seems feasible to be issued to investors?

Hope my question sounded clear. I really hope to share some personal opinions about this.

Thanks in advance.

## Answer by dm63 (score 1, accepted)

https://quant.stackexchange.com/a/66658

There is actually a reasonable rationale for the trade: As OP mentions, the forward value of CMS30 - CMS2 is close to zero for expirations beyond 5yrs, so the market assigns a significant probability that this spread will be negative. In other words, the risk-neutral probability of this quantity being negative is quite high (say 30pct). But, looking at historical time series, you see that this quantity is very rarely negative. In other words, the real world probability of this quantity being negative is quite low (say 5pct). Thus, on average it pays to sell these options. One might ask why the market does this ? In my opinion it is a variation of the common term structure ‘arbitrage’ whereby forward rates are too high , so in general it pays to receive fixed on interest rate swaps and ‘roll down the curve’.

These particular notes are being sold mostly to retail and institutional investors in the Far East (Korea, Taiwan). In most cases they cannot execute the trade in pure derivatives form and they are willing to pay a packaging fee to have a bank construct a note. Having said that , the worst that can happen to these notes is that they turn into zero coupon bonds, so the principal is protected assuming the bank issuer does not actually default.

## Answer by Dimitri Vulis (score 1)

https://quant.stackexchange.com/a/66650

Here is an example term sheet: https://www.sec.gov/Archives/edgar/data/70858/000119312512021960/d288901d424b2.htm .

Here's what I belive to be a typical scenario:

A high net worth individual, Alice, not very well informed about her investment choices, pays advisor Bob to invest her money in something more sophisticated than a passive index fund.

Bob buys for Alice notes like the above from Chris at a bank. Chris issues the notes and statically hedges them with swap having the same payoff with David at the swaps or rates exotics desk of same bank as Chris or a larger bank.

Everybody makes good money off of Alice. Alice pays much more to get this exposure than she would if she could trade the swap directly with David. Alice would have been better off with a passive index fund.